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New IRS Regulations on Intercompany Debt Transactions: Not Just a Tax Matter

The impacts of new IRS regulations governing intercompany debt transactions could potentially stretch beyond corporate tax departments to operational functions and, in some cases, strategic decision-making, at certain organizations. The rules, which are issued under Section 385 of the U.S. Tax Code, increase documentation requirements around intercompany debt transactions and under certain circumstances would recast debt between related parties as stock.

Christopher Trump

“CFOs, treasurers, tax directors and controllers may want to consider having candid conversations about the impact of the 385 regulations and whether the limitations on the ability to use debt in certain structures would significantly affect a transaction’s internal rate of return,” observes Christopher Trump, principal, Washington National Tax Office, Deloitte Tax LLP.

Released in October 2016, the final regulations apply to debt instruments issued by U.S. corporations and can apply to both U.S. debt issuers with foreign subsidiaries, as well as to multinational companies that own U.S. companies that have issued debt. It’s important to note that although the regulations have been finalized, there is some uncertainty in the current environment with respect to the future of these and other regulations, a situation that requires close monitoring over the coming months.

Melissa Cameron

“A big surprise for many companies in the final regulations is that the rules cover instruments other than intercompany loans, such as trade payables and receivables between subsidiaries in the corporate group,” says Melissa Cameron, principal, Deloitte Risk and Financial Advisory, and global treasury leader, Deloitte & Touche LLP. Ms. Cameron notes that the added focus on documentation and timely settlement of trade payables and receivables likely will require many organizations to assess and update related intercompany accounting processes and controls.

While the rules can be seen as a way to help protect the U.S. tax base from abusive practices, such as earnings stripping by multinationals, the final 385 regulations also have a heavy focus on increasing documentation for debt issued by U.S. corporations. The impetus behind the IRS’s increased documentation requirements seems rooted in the belief that debt transactions between related parties are not sufficiently documented and transaction terms are not observed in the same manner as third-party debt.

Valerie Dickerson

“Executives also should consider potential state taxation implications of the 385 rules, including organizations based or operating solely in the United States” says Valerie Dickerson, partner, Washington National Tax Office, Deloitte Tax LLP. She explains that under the 385 rules, members of a consolidated group required to file a consolidated U.S. federal income tax return are treated as one corporation. “As a result of partial state conformity to federal income tax regulations, businesses based in states that require taxable income to be computed beginning with pro forma federal income may have to apply the 385 rules separately for state and federal jurisdictions,” she adds. In other situations, absent state rules around the application of consolidated return regulations, organizations may have to provide different earnings and profit measures, as well as new basis calculations, to satisfy state and federal rules.

Four Indebtedness Factors

The documentation regulations, found in Section 385-2 of the final regulations, apply to debt transactions that take place after January 1, 2018, with documentation required to be completed by the time the organization’s next tax return is filed in 2019. For the transactions to be treated as debt, the 385-2 requirements impose a documentation prerequisite on certain related-party debt instruments. The rules generally require written documentation of four indebtedness factors:

—The issuer’s unconditional obligation to pay an agreed upon amount;

—The holder’s rights as a creditor;

—The issuer’s ability to repay the obligation; and

—The issuer’s and holder’s actions that provide evidence of a debtor-creditor relationship, such as payments of interest or principal and actions taken on default.

Sally Morrison

As a result, standalone financial statements and three-year financial projections may be needed. Challenging will be the ability to help track liquidity on a daily basis and understand whether future distributions could fall under the debt recharacterization rules. “If documentation requirements are not met, debt instruments covered by the rules could be treated as stock for federal tax purposes,” says Sally Morrison, partner, Deloitte Tax LLP.

“To comply effectively with 385 regulations, organizations will have to determine which businesses within their corporate group structure—and which debt instruments within those businesses—are covered by the 385 regulations,” notes Thomas Driscoll, partner, Deloitte Tax LLP.

Once covered transactions are identified, organizations are required to report and clear intercompany transactions within the provision’s ordinary course of 120 days. “These tasks can be challenging, especially for organizations that have to tap multiple ERP systems for large amounts of transactional data, clear those transactions, and provide an effective audit trail that documents adequate governance rules, procedures and controls,” observes Mr. Driscoll.

Thomas Driscoll

Potential Operational and Strategic Impacts

Corporate treasury functions also could be affected by the 385 regulations. Organizations may need to modernize liquidity management practices and systems, particularly with regard to visibility into global operations for managing cash and financial risk exposure. For instance, under the documentation rules, treasury functions could benefit from systems that view the global liquidity of each business within their corporate structure on a daily basis.

However, that kind of close monitoring could present challenges for some organizations, according to a Deloitte survey of more than 130 corporate treasury organizations. The survey found that 40% of respondents, many with dedicated treasury systems, thought their IT infrastructure was inadequate to provide adequate global visibility.

In addition, the new regulations could affect an organization’s decisions around strategy, including mergers and acquisitions. For example, the debt recharacterization provisions, referred to as the 385-3 rule, pertain to debt issued by a U. S. business that falls outside the consolidated group for federal income tax purposes. The recasting of debt as stock could affect the status of certain interest deductions used by organizations, as well, potentially prompting management to rethink how they approach transactions. M&A transactions that could fall into this category include acquisitions of unrelated companies and the integration of companies within a global consolidated group.

Reworking Processes to Prepare for the New Rules

For many organizations, addressing challenges that stem from the 385 regulations will require reengineering existing processes and systems while updating roles and responsibilities. In reworking financial processes it will be important to have clear communication from functional leaders so finance, treasury, tax and controllership teams agree on responsibilities, timelines and the governance over affected transactions. In addition, some organizations may need to set up cross-functional funding groups among the four functions to identify when particular transactions are taking place, or when to address situations in which subsidiaries may be unable to meet interest payments. In those cases, a governance committee charged with identifying red flags, such as non-payments, could provide proactive assistance in advance of defaults.

In general, controllers responsible for complying with 385 regulations will be looking to pull reports for aging intercompany payables and receivables on a timely basis, and potentially perform more in-depth financial information for credit analyses on an annual basis for borrowers falling within the scope of the regulations.

Documentation, standalone credit analysis and the ability to report and settle intercompany transactions on a timely basis may be new disciplines for some organizations that have not yet applied these processes to trade payables and receivables. Other organizations may find that additional resources in terms of both people and systems are needed in treasury and intercompany accounting departments to address new requirements. For example, under the new regulations, treasury teams will be required to manage cash concentration levels for the cash concentration header account as well as the individual subsidiary organizations, while accounting teams likely will need up-to-date systems to manage intercompany payables and receivables effectively. Specifically understanding and limiting cash pool borrowings to a maximum of 270 days (without looking for further working capital exemptions) will require additional capabilities and administration. For some companies, even simple management of intercompany transactions, such as ensuring intercompany interest payments are paid when due, may cause increased requirements for documentation and monitoring.

“When organizations peel back the onion on the 385 regulations, they may begin to see a number of significant operational challenges,” says Ms. Cameron. “It will be important for cross-functional teams to understand borrowing characteristics and limits—and the potential impact on the organization’s strategic decisions. It will also be critical to provide the necessary documentation, processes, controls and monitoring and, where needed, the technology to enable and scale these needs,” Ms. Cameron adds.

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